Stock Valuation - Common Stock

Valuation
Valuation methods typically fall into two main categories: absolute and relative.
Two Categories of Valuation Models
Absolute valuation models attempt to find the intrinsic or "true" value of an
investment based only on fundamentals. Looking at fundamentals simply means
you would only focus on such things as dividends, cash flow and growth rate for
a single company, and you wouldn't worry about any other companies. Valuation
models that fall into this category include the dividend discount
model, discounted cash flow model, residual income models and asset-based
models.
In contrast to absolute valuation models, relative valuation models operate by
comparing the company in question to other similar companies. These methods
generally involve calculating multiples or ratios, such as the price-toearningsmultiple, and comparing them to the multiples of other comparable firms.
For instance, if the P/E of the firm you are trying to value is lower than the P/E
multiple of a comparable firm, that company may be said to be relatively
undervalued. Generally, this type of valuation is a lot easier and quicker to do
than the absolute valuation methods, which is why many investors and analysts
start their analysis with this method.
Let's take a look at some of the more popular valuation methods available to
investors, and see when it is appropriate to use each model. (For related reading,
see Top Things To Know For An Investment Banking Interview.)
1. Dividend Discount Model (DDM)
The dividend discount model (DDM) is one of the most basic absolute valuation
models. The dividend model calculates the "true" value of a firm based on the
dividends the company pays its shareholders. The justification for using
dividends to value a company is that dividends represent the actual cash flows

going to the shareholder, thus valuing the present value of these cash flows
should give you a value for how much the shares should be worth. So, the first
thing you should check if you want to use this method is if the company actually
pays a dividend.
Secondly, it is not enough for the company to just a pay dividend; the dividend
should also be stable and predictable. The companies that pay stable and
predictable dividends are typically mature blue-chip companies in mature and
well-developed industries. These type of companies are often best suited for this
type of valuation method. For instance, take a look at the dividends and earnings
of company XYZ below and see if you think the DDM model would be
appropriate for this company:
2005
Dividends Per
$0.50
Share
Earnings Per Share $4.00

2006

2007

2008

2009

2010

$0.53
$4.20

$0.55
$4.41

$0.58
$4.63

$0.61
$4.86

$0.64
$5.11

In this example, the earnings per share are consistently growing at an average
rate of 5%, and the dividends are also growing at the same rate. This means the
firm's dividend is consistent with its earnings trend which would make it easy to
predict for future periods. In addition, you should check the payout ratio to make
sure the ratio is consistent. In this case the ratio is 0.125 for all six years, which is
good, and makes this company an ideal candidate for the dividend model. (For
more on the DDM, see Digging Into the Dividend Discount Model.)
2. Discounted Cash Flow Model (DCF)
What if the company doesn't pay a dividend or its dividend pattern is irregular? In
this case, move on to check if the company fits the criteria to use the discounted
cash flow model. Instead of looking at dividends, the DCF model uses a firm's
discounted future cash flows to value the business. The big advantage of this
approach is that it can be used with a wide variety of firms that don't pay
dividends, and even for companies that do pay dividends, such as company XYZ
in the previous example.
The DCF model has several variations, but the most commonly used form is the

Two-Stage DCF model. In this variation, the free cash flows are generally
forecasted for five to ten years, and then a terminal value is calculated to account
for all of the cash flows beyond the forecast period. So, the first requirement for
using this model is for the company to have predictable free cash flows, and for
the free cash flows to be positive. Based on this requirement alone, you will
quickly find that many small high-growth firms and non-mature firms will be
excluded due to the large capital expenditures these companies generally face.
For example, take a look at the simplified cash flows of the following firm:

Operating Cash
Flow
Capital
Expenditures
Free Cash Flow

2005

2006

2007

2008

2009

2010

438

789

1462

890

2565

510

785
-347

995
-206

1132
330

1256
-366

2235
330

1546
-1036

In this snapshot, the firm has produced increasingly positive operating cash flow,
which is good. But you can see by the high level of capital expenditures that the
company is still investing a lot of its cash back into the business in order to grow.
This results in negative free cash flows for four of the six years, making it
extremely difficult (nearly impossible) to predict the cash flows for the next five to
ten years. So, in order to use the DCF model most effectively, the target
company should generally have stable, positive and predictable free cash flows.
Companies that have the ideal cash flows suited for the DCF model are typically
the mature firms that are past the growth stages. (To learn more about this
method, see Taking Stock of Discounted Cash Flow.)
3. Comparables Method
The last method we'll look at is sort of a catch-all method that can be used if you
are unable to value the company using any of the other models, or if you simply
don't want to spend the time crunching the numbers. The method doesn't attempt
to find an intrinsic value for the stock like the previous two valuation methods do;
it simply compares the stock's price multiples to a benchmark to determine if the
stock is relatively undervalued or overvalued. The rationale for this is based off of
the Law of One Price, which states that two similar assets should sell for similar

prices. The intuitive nature of this method is one of the reasons it is so popular.
This method can be used in almost all circumstances because of the vast
number of multiples that can be applied, such as the price-to-earnings
(P/E), price-to-book (P/B), price-to-sales (P/S), price-to-cash flow (P/CF) and
many others. Of these ratios, the P/E ratio is the most commonly used one
because it focuses on the earnings of the company, which is one of the primary
drivers of an investment's value. (For more on this subject, see 6 Basic Financial
Ratios And What They Reveal.)
When can you use the P/E multiple for a comparison? You can generally use it if
the company is publicly traded because you need the price of the stock, and you
need to know the earnings of the company. Secondly, the company should be
generating positive earnings because a comparison using a negative P/E
multiple would be meaningless. And lastly, the earnings quality should be strong;
earnings should not be too volatile and the accounting practices used by
management should not drastically distort the reported earnings. (Companies
can manipulate their numbers, so you need to learn how to determine the
accuracy of EPS. Read How To Evaluate The Quality Of EPS.)
These are just some of the main criteria investors should look at when choosing
which ratio or multiples to use. If the P/E multiple cannot be used, simply look at
using a different ratio such as the price-to-sales multiple.
No one valuation method is perfect for every situation, but by knowing the
characteristics of the company, you can select the valuation method that best
suits the situation. In addition, investors are not limited to just using one method.
Often, investors will perform several valuations to create a range of possible
values or average all of the valuations into one.

Stock Valuation - Preferred Stock

Valuation
Preferred shares have the qualities of both a stock and a bond, which
makesvaluation a little different than a common share. The owner of the
preferred share is part owner of the company, just like a common shareholder.
The stake in the company is in proportion to the held stocks. Also, there is a fixed
payment which is similar to a bond issued by the company. The fixed payment is
in the form of a dividend and will be the basis of the valuation method for a
preferred share. These payments could come quarterly, monthly or yearly,
depending on the policy stated by the company.
Valuation
Preferred stocks have a fixed dividend, which means we can calculate the value
by discounting each of these payments to the present day. This fixed dividend is
not guaranteed in common shares. If you take these payments and calculate the
sum of the present values into perpetuity, you will find the value of the stock.
For example, if ABC Company pays a 25 cent dividend every month and the
required rate of return is 6% per year, then the expected value of the stock, using
the dividend discount approach, would be $0.25/0.005 = $50. The discount rate
was divided by 12 to get 0.005, but you could also use the yearly dividend of
(0.25*12) $3 and divide it by the yearly discount rate of 0.06 to get $50. The point
is that each issued dividend payment in the future needs to be discounted back
to the present and each value is then added together.

Where:

V = the value

D1 = the dividend next period

r = the required rate of return

Considerations
Although the preferred shares give a dividend, which is usually guaranteed, the
payment can be cut if there are not enough earnings to accommodate a
distribution. This risk of a cut payment needs to be accounted for. This risk
increases as the payout ratio (dividend payment compared to earnings) gets
higher. Also, if the dividend has a chance of growing, the value of the shares will
be higher than the result of the constant dividend calculation, given above.

Preferred shares usually lack the voting rights of common shares. This might be
a valuable feature to individuals who own large amounts of shares, but for the
average investor this voting right does not have much value. However, it still
needs to be accounted for when evaluating the marketability of preferred shares.

Preferred shares have an implied value similar to a bond. This means the value
will also move inversely with interest rates. When the interest rate goes up, the
value of the preferred shares will go down, holding everything else constant. This
is to account for other investment opportunities and is reflected in the discount
rate used.

Callable

If the preferred shares are callable, the company gains a benefit and the
purchaser should pay less, compared to if there was no call provision. The call
provision allows the company to basically take the shares off of the market at a
predetermined price. A company might add to this if the current market interest
rates are high (requiring a higher dividend payment) and the company expects
the interest rates to go down. This is a benefit to the issuing company, because
they can essentially issue new shares at a lower dividend payment. (Due to their
lowered price, callable shares pose risk: read Bond Call Features: Don't Get
Caught Off Guard.)

Growing Dividend
If the dividend has a history of predictable growth, or the company states a
constant growth will occur, you need to account for this. The calculation is known
as the Gordon Growth Model.

The added g is the growth of the payments.

By subtracting the growth number, the cash flows are discounted by a lower
number resulting in a higher value.

Preferred shares are a type of equity investment, which provide a steady stream
of income and potential appreciation. Both of these features need to be taken
into account when attempting to determine value. Calculations using the dividend
discount model are difficult because of the assumptions involved, such as the
required rate of return and the growth or length of higher returns.

The dividend payment is usually easy to find; the difficult part comes when this
payment is changing or potentially could change in the future. Also, finding a
proper discount rate is very difficult and if this figure is off, it could drastically
change the calculated value of the shares. When it comes to classroom
homework, these numbers will be simply given, but in the real world we are left to
estimate the discount rate or pay a company to do the calculation.

Stock Valuation - Stock Market

Reporting
One of the primary tools for reporting stock market activity is the ticker tape.
You've seen them on business programs or financial news networks: a flashing
series of baffling letters, arrows and numbers scrolling along the bottom of your
TV screen. (For a short history of the letters, read The Evolution Of Ticker
Symbols and Wall Street History: Windows 1.0 And Ticker-Tape Parades.)
While many people simply block out the ticker tape, others use it to stay on top of
market sentiment and track the activity of certain stocks. But what exactly is that
cryptic script reeling by? It obviously tells us something about stocks and the
markets, but how does one understand the ticker tape and use it to his or her
advantage?
Brief History
Firstly, a tick is any movement, up or down, however small, in the price of a
security. Hence, a ticker tape automatically records each transaction that occurs
on the exchange floor, including trading volume, onto a narrow strip of paper, or
tape.
The first ticker tape was developed in 1867, following the advent of the telegraph
machine, which allowed for information to be printed in easy-to-read scripts.
During the late 19th century, most brokers who traded at the New York Stock
Exchange (NYSE) kept an office near it to ensure they were getting a steady
supply of the tape and thus the most recent transaction figures of stocks. These

latest quotes were delivered by messengers, or "pad shovers," who ran a circuit
between the trading floor and brokers' offices. The shorter the distance between
the trading floor and the brokerage, the more up-to-date the quotes were.
Ticker-tape machines introduced in 1930 and 1964 were twice as fast as their
predecessors, but they still had about a 15-20 minute delay between the time of
a transaction and the time it was recorded. It wasn't until 1996 that a real-time
electronic ticker was launched. It is these up-to-the-minute transaction figures namely price and volume - that we see today on TV news shows, financial wires
and websites. And while the actual tape has been done away with, it has retained
the name. (See How Has The Stock Market Changed? to learn more about the
evolution of trading.)
Due to the nature of the markets, investors from all corners of the globe are
trading a variety of stocks in different lots and blocks at any given time. Therefore
what you see one minute on a ticker could change the next, particularly for those
stocks with high trading volume, and it could be some time before you see
your ticker symbol appear again with the latest trading activity.
Reading the Ticker Tape
Here's an example of a quote shown on a typical ticker tape:

The unique characters used to identify the company.

The volume for the trade being quoted. Abbreviations are
Shares Traded
K = 1,000, M = 1,000,000 and B = 1,000,000,000.
The price per share for the particular trade (the
Price Traded
last bid price).
Shows whether the stock is trading higher or lower than
Change Direction
the previous day\'s closing price.
Ticker Symbol

Change Amount

The difference in price from the previous day\'s close.

Throughout the trading day, these quotes will continually scroll across the screen
of financial channels or wires, showing current, or slightly delayed, data. In most
cases the ticker will quote only stocks of one exchange, but it is common to see
the numbers of two exchanges scrolling across the screen.
You can tell where a stock trades by looking at the number of letters in the stock
symbol. If the symbol has three letters, the stock likely trades on the NYSE
orAmerican Stock Exchange (AMEX). A four-letter symbol indicates the stock
likely trades on the Nasdaq. Some Nasdaq stocks have five letters, which usually
means the stock is foreign. This is designated by an 'F' or 'Y' at the end of the
stock symbol. To learn more, see Why do some stock symbols have three letters
while others have four?
On many tickers, colors are also used to indicate how the stock is trading. Here
is the color scheme most TV networks use:
Green indicates the stock is trading higher than the previous day\'s close.
Red indicates the stock is trading lower than the previous day\'s close.
Blue or white means the stock is unchanged from the previous closing price.

Before 2001, stocks were quoted as a fraction, but with the emergence
ofdecimalization all stocks on the NYSE and Nasdaq trade as decimals. The
advantage to investors and traders is that decimalization allows investors to enter
orders to the penny (as opposed to fractions like 1/16).
Which Quotes Get Priority?
There are literally millions of trades executed on more than 10,000 different
stocks each and every day. As you can imagine, it's impossible to report every
single trade on the ticker tape. Quotes are selected according to several factors,
including the stocks' volume, price change, how widely they are held and if there
is significant news surrounding the companies.

For example, a stock that trades 10 million shares a day will appear more times
on the ticker tape than a small stock that trades 50,000 shares a day. Or if a
smaller company not usually featured on the ticker has some ground-breaking
news, it will likely be added to the ticker. The only times the quotes are shown in
predetermined order are before the trading day starts and after it has finished. At
those times, the ticker simply displays the last quote for all stocks in alphabetical
order.
Constantly watching a ticker tape is not the best way to stay informed about the
markets, but many believe it can provide some insight. Tick indicators are used
to easily identify those stocks whose last trade was either an uptick or adowntick.
This is used as an indicator of market sentiment for determining the market's
trend.
So next time you're watching TV or surfing a website with a ticker, you'll
understand what all those numbers and symbols scrolling across your screen
really mean. Just remember that it can be near impossible to see the exact price
and volume at the precise moment it is being traded. Think of a ticker tape as
providing you with a general picture of a stock's "current" activity.
Stock tables are another source of stock market reporting. Open any financial
paper and you will see stock quotes that look something like the image below. In
this section, we'll explain how to make sense of these tables so that you can use
the information to your advantage.
Let's take a look at the stock/quotes table:

Columns 1 & 2: 52-Week High and Low. These are the highest and lowest
prices at which a stock has traded over the past 52 weeks (one year). This
typically does not include the previous day's trading.
Column 3: Company Name and Type of Stock. This column lists the name of
the company. If there are no special symbols or letters following the name, it
iscommon stock. Different symbols imply different classes of shares. For
example, "pf" means the shares are preferred stock.
Column 4: Ticker Symbol. This is the unique alphabetic name which identifies
the stock. If you watch financial TV, the ticker tape will quote the latest prices
alongside this symbol. If you are looking for stock quotes online, you always
search for a company by the ticker symbol. If you don't know a particular
company's ticker symbol, you can search for it at sites like Investopedia.
Column 5: Dividend Per Share. This indicates the annual dividend payment per
share. If this space is blank, the company does not currently pay out dividends.
Column 6: Dividend Yield. This is the percentage return on the dividend.
Dividend yield is calculated as annual dividends per share divided by price per
share.
Column 7: Price/Earnings Ratio (P/E ratio). This is calculated by dividing the
current stock price by earnings per share from the last four quarters. (For more

on how to interpret this, see Understand The P/E Ratio.)

Column 8: Trading Volume. This figure shows the total number of shares
traded for the day, listed in hundreds. To get the actual number traded, add two
zeros to the end of the number listed.
Column 9 & 10: Day High and Low. This indicates the price range in which the
stock has traded throughout the day. In other words, these are the maximum and
the minimum prices that people have paid for the stock.
Column 11: Close. The close is the last trading price recorded when the market
closed on the day. If the closing price is more than 5% above or below the
previous day's close, the entire listing for that stock is bold-faced. Keep in mind,
you are not guaranteed to get this price if you buy the stock the next day
because the price is constantly changing, even after the exchange is closed for
the day. The close is merely an indicator of past performance and, except in
extreme circumstances, it serves as a ballpark of what you should expect to pay.
Column 12: Net Change. This is the dollar value change in the stock price from
the previous day's closing price. When you hear about a stock being "up for the
day," it means the net change was positive.
Quotes on the Internet
Nowadays, it's far more convenient for most people to get stock quotes off the
internet. This method is superior because most sites update throughout the day
and give you more information, news, charting and research.